Uncle Sam Wants You Investing In Poor Areas

Capital gains are a good problem but a tax problem nonetheless. An excellent new way to defer paying tax on a capital gain is by investing in an area designated by Uncle Sam as an Opportunity Zone (OZ).

When you invest in a business or real estate project in an "OZ," capital gains taxes on selling stocks, a business, or any other investment can be deferred. You put pre-tax dollars to work in an OZ, which delays the capital gain taxes owed, and the extra investment of pre-tax dollars — if it generates profits — defrays your capital gain.

In effect, Uncle Sam wants you to become a venture capitalist in a low-income place. However, you take on the risk that the investment might go bust.

A burgeoning marketplace of OZ funds has developed and enables you to invest the proceeds of a capital gain into a fund set up to invest in an OZ. Getting in on a fund isn't cheap, however, and $1 million minimum investments are common. Immediately, your reinvested capital gain is tax-deferred, putting an additional 15% or 20% more into your OZ investment.

To be clear, capital gains on the federal level are taxed at the 15% rate, and at 20% for married couples filing jointly with more than $488,851 of adjusted gross income ($434,551 for singles). If you're in that tax bracket and sell a business or securities with a $1 million gain, instead of paying $150,000 or $200,000 in capital gains taxes, you can defer taxes owed by investing in an OZ.

You don't have to pay the gains tax until you sell your interest in the opportunity zone (OZ) fund. If you stay in the fund for five years, you pay tax on only 90% of your delayed capital gains. If your investment lasts for seven years, you pay tax on 85% of the gains. And if you stick around for 10 years, the appreciation on the OZ investment is tax-free when you exit the fund (assuming that the investment has increased, that is).

Let's say that a jewelry-making start-up you invested in has doubled in value. In addition to the capital gains reduction, your investment showed a tidy appreciation that you pocket without a tax bite. Along the way, you presumably would get a piece of any income the investments throw off, such as rent from a real estate development.

Some of these OZ areas are more down-and-out than others. The most prominent is Long Island City, a waterfront section of the New York borough of Queens, which just happens to be where Amazon is going to place one of its two new headquarters. Once a seedy stretch of vacant warehouses and factories, Long Island City had been gaining cachet even before the Amazon announcement in November. For the past few years, expensive residential high-rises have been sprouting up amid the post-industrial desolation. It stands to reason that an opportunity-zone investment in Long Island City has a better chance of yielding a great return than a slum in Buffalo, N.Y. Other gentrifying OZs include Oakland, Calif.; East Austin, Texas; and South Norwalk, Conn.

OZ investing may sound inspirational, but this is new turf in tax and financial planning. It requires personal tax planning and investment research to ensure investments have promise, are not too expensive and are aligned with your risk tolerance as well as social objectives, and we are happy to answer any questions.